Friday, 8 June 2012

The European Redemption Pact and Moral Hazard

In November 2011, the German Council of
Economic Experts has suggested a European
Redemption Pact (ERP) as a means of addressing the Eurozone financial
crisis. Under this scheme, which is quite similar to the Modest Proposal published by
Yiannis Varoufakis and Stuart Holland in November 2010. In the German proposal, the Eurozone countries
would pool their debt obligations over the Maastricht criterion, i.e. for that
debt portion over 60% of GDP. The amount over 60% would be jointly guaranteed
by the entire Eurozone. In the Varoufakis / Holland proposal, the inverse would occur: the European Central Bank would issue Eurobonds guaranteeing the first 60% of debt-to-GDP of all Eurozone countries.

In the German proposal, any
country not receiving support from the European Financial Stability Fund would
be able to “pool” their debt in a new financial structure, which would receive
a joint guarantee by every non-EFSF Eurozone member. (We note that Greece,
Ireland and Portugal are already in the EFSF and are thus presumably prevented
from participating).

Each Eurozone country would be able to
participate contingent on:

a. Introduce a constitutional
“debt brake”, i.e. a constitutional commitment to reduce debt to the Maastricht
level or below;

b. Introduce a specific national
economic plan with ring-fenced special tax provisions to debt service of both
its 60% debt-to-GDP and its debt guaranteed by the ERP.

c. It would have to sign over 20%
of gold and foreign exchange assets in its central banking system as collateral
for the ERP guarantee.

The German Council gives the example of
Italy, which it estimates would have to assure a primary surplus of 4.2% of
GDP, assuming Italian GDP grows at 3% per year, the ERP has a refinancing cost
of 4%, and Italy has an average 5% for its remaining debt.

This proposal is quite similar to the
revised Modest Proposal of Varoufakis and Holland. In the Modest Proposal, the
first 60% national debt limit would be refinanced using pEuropean Central Bank bonds. The Modest Proposal includes a commitment to growth, via loans provided by the European Investment Bank (EIB), as well as a commitment to austerity.

Both proposals accept, but fail to account
for, how the political and financial fundamentals of such a plan would work.

It is worth remembering that at the heart
of any financial transaction or system is the assumption of trust and
confidence. Absent this condition, no amount of loan covenants or collateral
guarantees will induce a borrower and a lender to enter into an agreement, let
alone respect it. This problem is currently magnified (a) between Eurozone
member states, and (b) between the Eurozone and the rest of the world.

Let’s take the political dimension first. Within
the confines of the Eurozone debate, the Germans are portrayed as martyred
taxpayers while the Greeks are condemned as spendthrift liars and thieves.
Whatever the truth of the situation, Europe’s politicians have sufficiently
poisoned the well of intra-Eurozone trust to the extent that it is now impossible
to conceive of a German taxpayer agreeing to pool liabilities in this way.

Outside the Eurozone, there is similarly little
confidence that the 17-member currency union has either the financial or the
political nous to get in front of the
problem, rather than trail haplessly behind it. There is also little evidence
that the International Monetary Fund has a handle on the situation, judging by
its record to date, and by recent remarks by its Managing Director.

Let’s now look briefly at the financial
dimension. In the Varoufakis / Holland proposal, the authors presume that the
ECB will guarantee the first 60% of debt:GDP. This will require a
massive increase of the ECB’s balance sheet assets, which are already
dangerously over-exposed from its direct purchases of sovereign debt and its
Long Term Refinancing Operations (LTRO) (and prior liquidity operations).

An ECB guarantee will only function as long
as the Eurosystem central banks take steps to expand their asset base
accordingly, while possibly increasing the ECB balance sheet independently.
Although this is possible, it will encounter important financial and practical
difficulties in the current climate.

In the German ERP proposal, the idea is for
an expanded EFSF/ESM to be created which would issue guarantees for
refinancing. This plan is slightly better in that (a) the EFSF countries are
presumably not included, and (b) there is a 20% collateral post as a specific
resource allocated to this fund. Furthermore, it counts a 4% ERP refinancing
cost, which is important in the current market. Most cash assets have fled to
havens which render a negative interest rate after inflation.

This does not answer the question whether
the 20% collateral post will be sufficient, or whether new collateral will have
to be raised (particularly in light of Eurosystem commitments to the ECB). But
at least this is a measurable indicator by which an interested analyst could run
various forecasts and simulations.

The deep problem with the ERP is the same
as that of the Eurobond: it makes each Eurozone country jointly and severally
liable for the debts of another Eurozone country. This is difficult to imagine
in the current political environment. It is also difficult to imagine
objectively: debt brakes and other frills aside, there is very little evidence
to suggest a country can be induced to maintain acceptable debt levels over
time. Particularly over the next 25 years, when Europe will have to cope with
dramatic demographic changes, and the damage these will create on national
pension systems.

My conclusion is that Europe is not ready
for such a move. On the one hand, it there is no political credibility for it,
either within or without the Eurozone. On the other hand, I have to ask why a
standard debt work-out process is so objectionable. This is hardly a new
feature of economic life, and in private sector occurs on a daily basis. Thus:

· If Spain fails to recapitalise
its banks, it should let its banks fail, and find other ways of managing the
fall-out for the benefit of its individual depositors or other “innocents”;

· If Greece fails to get its
public finances under control, it should default on its public debt, with all
the consequences this implies for current public spending and private
consumption.

I fail to see how increasingly complicated
financial support schemes remove the moral hazard implicit in investment
decisions made by governments or banks (or German owners of Spanish vacation
homes). Since they do not remove either moral hazard or basic human behaviour,
it is clear to me that neither a debt brake or a ring-fenced tax system will
survive over time. There will be myriad future opportunities to fiddle with public
or private expenditure over time, and particularly given the inevitable decay
of the European social model in the next 20 years.

Let me reiterate my comment on moral
hazard: both the Modest Proposal as well as the ERP suggest, and indeed are
based on the idea that lasting changes to human behaviour and debt incurrence
are possible as a result of an Eurozone financial structure. I see no evidence
for this either from economic history or from current affairs.

If we take the Greek case, for example, one
would assume that if “virtuous decisions” were possible, the entire political
class would have been replaced. In fact, the political class is intact, and
pursues the same failed policies and political tactics.

If we take the Spanish case, we see exactly
the same situation. The management of Spanish banks that over-lent are still
largely in place. The owners of Spanish property are still in place. The desire
to invest in property remains high, whether as a distressed asset, or as a
“dream home”. These same factors have led to so many property booms and busts
remain – European system or no system. It has nothing to do with a debt brake
or regular public spending.

As a result, I am in favour of using
classical debt work-out tools, either at the public or private levels, to
resolve this crisis. In my opinion, the well-meaning but flawed attempts by
Eurozone officials to solve the crisis by setting up support mechanisms prevent
a timely and cost-effective resolution to the crisis. Their efforts would be
better deployed in creating temporary social support mechanisms rather than by
increasingly complex and morally questionable bail outs of the banking system
which has contributed so much to this crisis.

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